Table Of Contents
1) Stocks Basics: Introduction
2) Stocks Basics: What Are Stocks?
3) Stocks Basics: Different Types Of Stocks
4) Stocks Basics: How Stocks Trade
5) Stocks Basics: What Causes Stock Prices To Change?
6) Stocks Basics: Buying Stocks
7) Stocks Basics: How To Read A Stock Table/Quote
8) Stocks Basics: The Bulls, The Bears And The Farm
9) Stocks Basics: Conclusion
Introduction
Wouldn't you love to be a business owner without ever having to show up at
work? Imagine if you could sit back, watch your company grow, and collect the
dividend checks as the money rolls in! This situation might sound like a pipe
dream, but it's closer to reality than you might think.
As you've probably guessed, we're talking about owning stocks. This fabulous
category of financial instruments is, without a doubt, one of the greatest tools
ever invented for building wealth. Stocks are a part, if not the cornerstone, of
nearly any investment portfolio. When you start on your road to financial
freedom, you need to have a solid understanding of stocks and how they trade
on the stock market.
Over the last few decades, the average person's interest in the stock market has
grown exponentially. What was once a toy of the rich has now turned into the
vehicle of choice for growing wealth. This demand coupled with advances in
trading technology has opened up the markets so that nowadays nearly anybody
can own stocks.
Despite their popularity, however, most people don't fully understand stocks.
Much is learned from conversations around the water cooler with others who also
don't know what they're talking about. Chances are you've already heard people
say things like, "Bob's cousin made a killing in XYZ company, and now he's got
another hot tip..." or "Watch out with stocks--you can lose your shirt in a matter of
days!" So much of this misinformation is based on a get-rich-quick mentality,
which was especially prevalent during the amazing dotcom market in the late
'90s. People thought that stocks were the magic answer to instant wealth with no
risk. The ensuing dotcom crash proved that this is not the case. Stocks can (and
do) create massive amounts of wealth, but they aren't without risks. The only
solution to this is education. The key to protecting yourself in the stock market is
to understand where you are putting your money.
It is for this reason that we've created this tutorial: to provide the foundation you
need to make investment decisions yourself. We'll start by explaining what a
stock is and the different types of stock, and then we'll talk about how they are
traded, what causes prices to change, how you buy stocks and much more.
What Are Stocks?
The Definition of a Stock
Plain and simple, stock is a share in the ownership of a company. Stock
represents a claim on the company's assets and earnings. As you acquire more
stock, your ownership stake in the company becomes greater. Whether you say
shares, equity, or stock, it all means the same thing.
Being an Owner
Holding a company's stock means that you are one of the many owners
(shareholders) of a company and, as such, you have a claim (albeit usually very
small) to everything the company owns. Yes, this means that technically you own
a tiny sliver of every piece of furniture, every trademark, and every contract of the
company. As an owner, you are entitled to your share of the company's earnings
as well as any voting rights attached to the stock.
A stock is represented by a stock certificate. This is a fancy piece of paper that is
proof of your ownership. In today's computer age, you won't actually get to see this
document because your brokerage keeps these records electronically, which is also
known as holding shares "in street name". This is done to make the shares easier to
trade. In the past, when a person wanted to sell his or her shares, that person physically
took the certificates down to the brokerage. Now, trading with a click of the mouse
or a phone call makes life easier for everybody.
Being a shareholder of a public company does not mean you have a say in the
day-to-day running of the business. Instead, one vote per share to elect the board
of directors at annual meetings is the extent to which you have a say in the company.
For instance, being a Microsoft shareholder doesn't mean you can call up Bill Gates
and tell him how you think the company should be run. In the same line of thinking,
being a shareholder of Anheuser Busch doesn't mean you can walk into the factory
and grab a free case of Bud Light!
The management of the company is supposed to increase the value of the firm
for shareholders. If this doesn't happen, the shareholders can vote to have the
management removed, at least in theory. In reality, individual investors like you
and I don't own enough shares to have a material influence on the company. It's
really the big boys like large institutional investors and billionaire entrepreneurs
who make the decisions.
For ordinary shareholders, not being able to manage the company isn't such a
big deal. After all, the idea is that you don't want to have to work to make money,
right? The importance of being a shareholder is that you are entitled to a portion
of the company’s profits and have a claim on assets. Profits are sometimes paid
out in the form of dividends. The more shares you own, the larger the portion of
the profits you get. Your claim on assets is only relevant if a company goes
bankrupt. In case of liquidation, you'll receive what's left after all the creditors
have been paid. This last point is worth repeating: the importance of stock
ownership is your claim on assets and earnings. Without this, the stock
wouldn't be worth the paper it's printed on.
Another extremely important feature of stock is its limited liability, which means
that, as an owner of a stock, you are not personally liable if the company is not
able to pay its debts. Other companies such as partnerships are set up so that if
the partnership goes bankrupt the creditors can come after the partners
(shareholders) personally and sell off their house, car, furniture, etc. Owning
stock means that, no matter what, the maximum value you can lose is the value
of your investment. Even if a company of which you are a shareholder goes
bankrupt, you can never lose your personal assets.
Debt vs. Equity
Why does a company issue stock? Why would the founders share the profits with
thousands of people when they could keep profits to themselves? The reason is
that at some point every company needs to raise money. To do this, companies
can either borrow it from somebody or raise it by selling part of the company,
which is known as issuing stock. A company can borrow by taking a loan from a
bank or by issuing bonds. Both methods fit under the umbrella of debt financing.
On the other hand, issuing stock is called equity financing. Issuing stock is
advantageous for the company because it does not require the company to pay
back the money or make interest payments along the way. All that the
shareholders get in return for their money is the hope that the shares will
someday be worth more than what they paid for them. The first sale of a stock,
which is issued by the private company itself, is called the initial public offering
(IPO).
It is important that you understand the distinction between a company financing
through debt and financing through equity. When you buy a debt investment such
as a bond, you are guaranteed the return of your money (the principal) along with
promised interest payments. This isn't the case with an equity investment. By
becoming an owner, you assume the risk of the company not being successful -
just as a small business owner isn't guaranteed a return, neither is a shareholder.
As an owner, your claim on assets is less than that of creditors. This means that if
a company goes bankrupt and liquidates, you, as a shareholder, don't get any
money until the banks and bondholders have been paid out; we call
this absolute priority. Shareholders earn a lot if a company is successful, but they
also stand to lose their entire investment if the company isn't successful.
Risk
It must be emphasized that there are no guarantees when it comes to individual
stocks. Some companies pay out dividends, but many others do not. And there is
no obligation to pay out dividends even for those firms that have traditionally
given them. Without dividends, an investor can make money on a stock only
through its appreciation in the open market. On the downside, any stock may go
bankrupt, in which case your investment is worth nothing.
Although risk might sound all negative, there is also a bright side. Taking on
greater risk demands a greater return on your investment. This is the reason why
stocks have historically outperformed other investments such as bonds or
savings accounts. Over the long term, an investment in stocks has historically
had an average return of around 10-12%.
Different Types Of Stocks
There are two main types of stocks: common stock and preferred stock.
Common Stock
Common stock is, well, common. When people talk about stocks they are usually
referring to this type. In fact, the majority of stock is issued is in this form. We
basically went over features of common stock in the last section. Common
shares represent ownership in a company and a claim (dividends) on a portion of
profits. Investors get one vote per share to elect the board members, who
oversee the major decisions made by management.
Over the long term, common stock, by means of capital growth, yields higher
returns than almost every other investment. This higher return comes at a cost
since common stocks entail the most risk. If a company goes bankrupt and
liquidates, the common shareholders will not receive money until the creditors,
bondholders and preferred shareholders are paid.
Preferred Stock
Preferred stock represents some degree of ownership in a company but usually
doesn't come with the same voting rights. (This may vary depending on the
company.) With preferred shares, investors are usually guaranteed a fixed
dividend forever. This is different than common stock, which has variable
dividends that are never guaranteed. Another advantage is that in the event of
liquidation, preferred shareholders are paid off before the common shareholder
(but still after debt holders). Preferred stock may also be callable, meaning that
the company has the option to purchase the shares from shareholders at anytime
for any reason (usually for a premium).
Some people consider preferred stock to be more like debt than equity. A good
way to think of these kinds of shares is to see them as being in between bonds
and common shares.
Different Classes of Stock
Common and preferred are the two main forms of stock; however, it's also
possible for companies to customize different classes of stock in any way they
want. The most common reason for this is the company wanting the voting power
to remain with a certain group; therefore, different classes of shares are given
different voting rights. For example, one class of shares would be held by a
select group who are given ten votes per share while a second class would be
issued to the majority of investors who are given one vote per share.
When there is more than one class of stock, the classes are traditionally
designated as Class A and Class B. Berkshire Hathaway (ticker: BRK), has two
classes of stock. The different forms are represented by placing the letter behind
the ticker symbol in a form like this: "BRKa, BRKb" or "BRK.A, BRK.B".
How Stocks Trade
Most stocks are traded on exchanges, which are places where buyers and
sellers meet and decide on a price. Some exchanges are physical locations
where transactions are carried out on a trading floor. You've probably seen
pictures of a trading floor, in which traders are wildly throwing their arms up,
waving, yelling, and signaling to each other. The other type of exchange is
virtual, composed of a network of computers where trades are made
electronically.
The purpose of a stock market is to facilitate the exchange of securities between
buyers and sellers, reducing the risks of investing. Just imagine how difficult it
would be to sell shares if you had to call around the neighborhood trying to find a
buyer. Really, a stock market is nothing more than a super-sophisticated farmers'
market linking buyers and sellers.
Before we go on, we should distinguish between the primary market and the
secondary market. The primary market is where securities are created (by means
of an IPO) while, in the secondary market, investors trade previously-issued
securities without the involvement of the issuing-companies. The secondary
market is what people are referring to when they talk about the stock market. It is
important to understand that the trading of a company's stock does not directly
involve that company.
The New York Stock Exchange
The most prestigious exchange in the world is the New York Stock Exchange
(NYSE). The "Big Board" was founded over 200 years ago in 1792 with the
signing of the Buttonwood Agreement by 24 New York City stockbrokers and
merchants. Currently the NYSE, with stocks like General Electric, McDonald's,
Citigroup, Coca-Cola, Gillette and Wal-mart, is the market of choice for the
largest companies in America.
The NYSE is the first type of exchange (as we referred to
above), where much of the trading is done face-to-face on
a trading floor. This is also referred to as a listed exchange.
Orders come in through brokerage firms that are members
of the exchange and flow down to floor brokers who go to a
specific spot on the floor where the stock trades. At this
location, known as the trading post, there is a specific
person known as the specialist whose job is to match
buyers and sellers. Prices are determined using an auction
method: the current price is the highest amount any buyer
is willing to pay and the lowest price at which someone is
willing to sell. Once a trade has been made, the details are
sent back to the brokerage firm, who then notifies the
investor who placed the order. Although there is human contact in this process,
don't think that the NYSE is still in the stone age: computers play a huge role in
the process.
The Nasdaq
The second type of exchange is the virtual sort called an over-the-counter (OTC)
market, of which the Nasdaq is the most popular. These markets have no central
location or floor brokers whatsoever. Trading is done through a computer and
telecommunications network of dealers. It used to be that the largest companies
were listed only on the NYSE while all other second tier stocks traded on the
other exchanges. The tech boom of the late '90s changed all this; now the
Nasdaq is home to several big technology companies such as Microsoft,
Cisco,Intel, Dell and Oracle. This has resulted in the Nasdaq
becoming a serious competitor to the NYSE.
On the Nasdaq brokerages act as market makers for various
stocks. A market maker provides continuous bid and ask
prices within a prescribed percentage spread for shares for
which they are designated to make a market. They may
match up buyers and sellers directly but usually they will
maintain an inventory of shares to meet demands of
investors.
Other Exchanges
The third largest exchange in the U.S. is the American Stock
Exchange (AMEX). The AMEX used to be an alternative to
the NYSE, but that role has since been filled by the Nasdaq. In fact, the National
Association of Securities Dealers (NASD), which is the parent of Nasdaq, bought
the AMEX in 1998. Almost all trading now on the AMEX is in small-cap stocks
and derivatives.
There are many stock exchanges located in just about every country around the
world. American markets are undoubtedly the largest, but they still represent only
a fraction of total investment around the globe. The two other main financial hubs
are London, home of the London Stock Exchange, and Hong Kong, home of the
Hong Kong Stock Exchange. The last place worth mentioning is the over-the counter
bulletin board (OTCBB). The Nasdaq is an over-the-counter market, but
the term commonly refers to small public companies that don’t meet the listing
requirements of any of the regulated markets, including the Nasdaq. The OTCBB
is home to penny stocks because there is little to no regulation. This makes
investing in an OTCBB stock very risky.
What Causes Stock Prices To Change?
Stock prices change every day as a result of market forces. By this we mean that
share prices change because of supply and demand. If more people want to buy
a stock (demand) than sell it (supply), then the price moves up. Conversely, if
more people wanted to sell a stock than buy it, there would be greater supply
than demand, and the price would fall.
Understanding supply and demand is easy. What is difficult to comprehend is
what makes people like a particular stock and dislike another stock. This comes
down to figuring out what news is positive for a company and what news is
negative. There are many answers to this problem and just about any investor
you ask has their own ideas and strategies.
That being said, the principal theory is that the price movement of a stock
indicates what investors feel a company is worth. Don't equate a company's
value with the stock price. The value of a company is its market capitalization,
which is the stock price multiplied by the number of shares outstanding. For
example, a company that trades at $100 per share and has 1 million shares
outstanding has a lesser value than a company that trades at $50 that has 5
million shares outstanding ($100 x 1 million = $100 million while $50 x 5 million =
$250 million). To further complicate things, the price of a stock doesn't only
reflect a company's current value, it also reflects the growth that investors expect
in the future.
The most important factor that affects the value of a company is its earnings.
Earnings are the profit a company makes, and in the long run no company can
survive without them. It makes sense when you think about it. If a company never
makes money, it isn't going to stay in business. Public companies are required to
report their earnings four times a year (once each quarter). Wall Street watches
with rabid attention at these times, which are referred to as earnings seasons.
The reason behind this is that analysts base their future value of a company on
their earnings projection. If a company's results surprise (are better than
expected), the price jumps up. If a company's results disappoint (are worse than
expected), then the price will fall.
Of course, it's not just earnings that can change the sentiment towards a stock
(which, in turn, changes its price). It would be a rather simple world if this were
the case! During the dotcom bubble, for example, dozens of internet companies
rose to have market capitalizations in the billions of dollars without ever making
even the smallest profit. As we all know, these valuations did not hold, and most
internet companies saw their values shrink to a fraction of their highs. Still, the
fact that prices did move that much demonstrates that there are factors other
than current earnings that influence stocks. Investors have developed literally
hundreds of these variables, ratios and indicators. Some you may have already
heard of, such as the price/earnings ratio, while others are extremely complicated
and obscure with names like Chaikin oscillator or moving average convergence
divergence.
So, why do stock prices change? The best answer is that nobody really knows
for sure. Some believe that it isn't possible to predict how stock prices will
change, while others think that by drawing charts and looking at past price
movements, you can determine when to buy and sell. The only thing we do know
is that stocks are volatile and can change in price extremely rapidly.
The important things to grasp about this subject are the following:
1. At the most fundamental level, supply and demand in the market determines
stock price.
2. Price times the number of shares outstanding (market capitalization) is the
value of a company. Comparing just the share price of two companies is
meaningless.
3. Theoretically, earnings are what affect investors' valuation of a company, but
there are other indicators that investors use to predict stock price. Remember, it
is investors' sentiments, attitudes and expectations that ultimately affect stock
prices.
4. There are many theories that try to explain the way stock prices move the way
they do. Unfortunately, there is no one theory that can explain everything.
Buying Stocks
You've now learned what a stock is and a little bit about the principles behind the
stock market, but how do you actually go about buying stocks? Thankfully, you
don't have to go down into the trading pit yelling and screaming your order. There
are two main ways to purchase stock:
1. Using a Brokerage
The most common method to buy stocks is to use a brokerage. Brokerages
come in two different flavors. Full-service brokerages offer you (supposedly)
expert advice and can manage your account; they also charge a lot. Discount
brokerages offer little in the way of personal attention but are much cheaper.
At one time, only the wealthy could afford a broker since only the expensive, full service
brokers were available. With the internet came the explosion of online
discount brokers. Thanks to them nearly anybody can now afford to invest in the
market.
2. DRIPs & DIPs
Dividend reinvestment plans (DRIPs) and direct investment plans (DIPs) are
plans by which individual companies, for a minimal cost, allow shareholders to
purchase stock directly from the company. Drips are a great way to invest small
amounts of money at regular intervals.
How to Read a Stock Table/Quote
52-Week Hi and Low - These are the highest and lowest prices
at which a stock has traded over the previous 52 weeks (one year). This typically
does not include the previous day's trading.
Company Name & Type of Stock - This column lists the name of
the company. If there are no special symbols or letters following the name, it is
common stock. Different symbols imply different classes of shares. For example,
"pf" means the shares are preferred stock.
Ticker Symbol - This is the unique alphabetic name which identifies
the stock. If you watch financial TV, you have seen the ticker tape move across
the screen, quoting the latest prices alongside this symbol. If you are looking for
stock quotes online, you always search for a company by the ticker symbol. If
you don't know what a particular company's ticker is you can search for it at:
http://finance.yahoo.com/l.
Dividend Per Share - This indicates the annual dividend payment
per share. If this space is blank, the company does not currently pay out
dividends.
Dividend Yield – This states the percentage return on the dividend,
calculated as annual dividends per share divided by price per share.
Price/Earnings Ratio - This is calculated by dividing the current
stock price by earnings per share from the last four quarters.
Trading Volume - This figure shows the total number of shares
traded for the day, listed in hundreds. To get the actual number traded, add "00"
to the end of the number listed.
Day High & Low - This indicates the price range at which the
stock has traded at throughout the day. In other words, these are the maximum
and the minimum prices that people have paid for the stock.
Close - The close is the last trading price recorded when the market
closed on the day. If the closing price is up or down more than 5% than the
previous day's close, the entire listing for that stock is bold-faced. Keep in mind,
you are not guaranteed to get this price if you buy the stock the next day
because the price is constantly changing (even after the exchange is closed for
the day). The close is merely an indicator of past performance and except in
extreme circumstances serves as a ballpark of what you should expect to pay.
Net Change - This is the dollar value change in the stock price from
the previous day's closing price. When you hear about a stock being "up for the
day," it means the net change was positive.
Quotes on the Internet
Nowadays, it's far more convenient for most to get stock quotes off the Internet.
This method is superior because most sites update throughout the day and give
you more information, news, charting, research, etc.
To get quotes, simply enter the ticker symbol into the quote box of any major
financial site like Yahoo Finance, CBS Marketwatch, or MSN Moneycentral. The
example below shows a quote for Microsoft (MSFT) from Yahoo Finance.
Interpreting the data is exactly the same as with the newspaper.
The Bulls, The Bears And The Farm On Wall Street, the bulls and bears are in a
constant struggle. If you haven't heard of these terms already, you undoubtedly
will as you begin to invest.
The Bulls
A bull market is when everything in the economy is great, people are finding
jobs, gross domestic product (GDP) is growing, and stocks are rising. Things are
just plain rosy! Picking stocks during a bull market is easier because everything
is going up. Bull markets cannot last forever though, and sometimes they can
lead to dangerous situations if stocks become overvalued. If a person is
optimistic and believes that stocks will go up, he or she is called a "bull" and is
said to have a "bullish outlook".
The Bears
A bear market is when the economy is bad, recession is looming and stock
prices are falling. Bear markets make it tough for investors to pick profitable
stocks. One solution to this is to make money when stocks are falling using a
technique called short selling. Another strategy is to wait on the sidelines until
you feel that the bear market is nearing its end, only starting to buy in anticipation
of a bull market. If a person is pessimistic, believing that stocks are going to drop,
he or she is called a "bear" and said to have a "bearish outlook".
The Other Animals on the Farm - Chickens and Pigs
Chickens are afraid to lose anything. Their fear overrides their need to make
profits and so they turn only to money-market securities or get out of the markets
entirely. While it's true that you should never invest in something over which you
lose sleep, you are also guaranteed never to see any return if you avoid the
market completely and never take any risk,
Pigs are high-risk investors looking for the one big score in a short period of time.
Pigs buy on hot tips and invest in companies without doing their due diligence.
They get impatient, greedy, and emotional about their investments, and they are
drawn to high-risk securities without putting in the proper time or money to learn
about these investment vehicles. Professional traders love the pigs, as it's often
from their losses that the bulls and bears reap their profits.
What Type of Investor Will You Be?
There are plenty of different investment styles and strategies out there. Even
though the bulls and bears are constantly at odds, they can both make money
with the changing cycles in the market. Even the chickens see some returns,
though not a lot. The one loser in this picture is the pig.
Make sure you don't get into the market before you are ready. Be conservative
and never invest in anything you do not understand. Before you jump in without
the right knowledge, think about this old stock market saying:
"Bulls make money, bears make money, but pigs just get slaughtered!"
Conclusion
Let's recap what we've learned in this tutorial:
Stock means ownership. As an owner, you have a claim on the assets and
earnings of a company as well as voting rights with your shares.
Stock is equity, bonds are debt. Bondholders are guaranteed a return on
their investment and have a higher claim than shareholders. This is
generally why stocks are considered riskier investments and require a
higher rate of return.
You can lose all of your investment with stocks. The flip-side of this is you
can make a lot of money if you invest in the right company.
The two main types of stock are common and preferred. It is also possible
for a company to create different classes of stock.
Stock markets are places where buyers and sellers of stock meet to trade.
The NYSE and the Nasdaq are the most important exchanges in the
United States.
Stock prices change according to supply and demand. There are many
factors influencing prices, the most important of which is earnings.
There is no consensus as to why stock prices move the way they do.
To buy stocks you can either use a brokerage or a dividend reinvestment
plan (DRIP).
Stock tables/quotes actually aren't that hard to read once you know what
everything stands for!
Bulls make money, bears make money, but pigs get slaughtered!
